Capital markets began 2023 on a positive note, with most indices achieving first-quarter gains. Volatility was high however, caused by banking sector issues, inflation, monetary policy and recession concerns.
It has been more than 30 days since Silicon Valley Bank and Signature Bank failed. Media coverage has been broad, so we will not reiterate what has already widely been reported. Instead, we will add a brief perspective.
The bank failures were primarily due to rapid growth, depositor concentrations and most critically, mismanagement. The banking sector as a whole is well capitalized and adequately supported by the Federal Deposit Insurance Corporation and Fed lending facilities, should they be necessary. These programs are features of a strong U.S. banking system and should not be interpreted as a sign of systemic weakness. If additional banks fail (and some may), it will likely be due to isolated mismanagement, not financial contagion.
All that said, the abrupt shift in Fed monetary policy over the trailing 12-month period has forced banking sector adjustments. Higher borrowing costs, along with elevated risks of a U.S. recession, have increased lending standards and decreased available credit. These conditions are additive to the economic headwinds of the Fed’s already restrictive monetary policy.
Now let’s turn our attention to the economic data and how capital markets evolved during the quarter.
The Consumer Price Index (CPI) declined to 5% in March, well below the 9% peak last June. While inflation is on a clear downward trajectory, it remains above long run averages and the Fed’s 2% target, as shown on the right-hand side of the chart below.
Shelter represents nearly 35% of CPI – it alone increased 8.2% year-over-year. The cost of shelter has been challenging due to shortages in affordable housing and construction labor. Until this imbalance is resolved, CPI will likely remain stubbornly high.
The U.S. labor market continues to show remarkable strength. Non-farm payrolls grew by 236,000 jobs in March, bringing the unemployment rate to 3.5% – a level close to all-time lows. Year-over-year wage growth stood at 4.2%, and the number of unfilled job openings reached 9.9 million. Additionally, the labor force participation rate improved to 62.6%, a mere 0.7% below pre-pandemic levels.
Labor market strength is a contributing factor to inflation and gives the Fed justification to keep interest rates higher for longer if necessary.
The Fed is projecting another 25 basis point increase next month and a “mild recession” later this year. The fact that the Fed is forecasting a recession and another increase in interest rates speaks volumes about its commitment to address inflation. The market on the other hand, is doubting the Fed’s resolve.
The chart below shows the Fed’s current projections for short term interest rates (blue line) and the implied yields from the interest rate futures market (orange line). The market expects lower peak interest rates to occur in the current quarter, rate cuts by the third quarter, and year-end rates about 70 basis points lower than the Fed’s public projection. This market outlook has supported interest rate sensitive asset valuations, particularly long-duration bonds and large-cap growth stocks.
The discrepancy between these forecasts suggests vastly different economic scenarios. If the Fed is correct, it implies that the balance of economic data – mainly inflation and labor conditions – will warrant restrictive monetary policy through the end of the year. In contrast if the market is correct, it implies that the economy will deteriorate enough this year to motivate the Fed to pivot from tight monetary policy to one that is more accommodating. Given the current strength of the labor market, this scenario seems unlikely without expectations of an imminent recession.
On June 14th the Fed will update its projections, which will provide insight to the committee’s perspective, and whether or not there is convergence with the market’s point of view.
The majority of the yield curve trended lower during the quarter, resulting in positive total returns for fixed income indices. The Bloomberg US Aggregate Bond index returned +3.0% and the Bloomberg Municipal 1-10 year index returned +2.0%. Despite lower intermediate and long term yields at quarter-end, we continue to see value in core fixed income and preferred stocks.
The S&P 500 index returned +7.5% including dividends during the quarter. For the last six months, the index has bounced around between the lows of last year and a February high mark. We don’t know if this volatility is the beginning of a new bull market or an unsustainable bear market rally, only time will tell.
Declining interest rates supported large-cap growth stock outperformance (+14.4%), while regional bank stress pressured small-cap value stock underperformance (-0.7%). Notably, the quarter’s three best performing S&P 500 stocks – NVIDIA (+90%), Meta Platforms (+76%) and Tesla (+68%) – were some of last year’s worst performers, -50%, -64%, and -65%, respectively.
As of quarter-end, analysts’ consensus estimates expect double digit earnings growth for S&P 500 companies in 2023. The index’s valuation is 17.8x those forward estimates, which is slightly above historical averages.
Inflation and interest rates remain elevated in the U.S., and should the economy weaken or fall into recession, forward earnings estimates and above average valuations may be overly optimistic.
Looking abroad, developed international markets returned +8.5%, while emerging markets returned +4%. On balance, declining energy prices, a weakening U.S. dollar and improving economic growth outweighed isolated geopolitical risks and inflation concerns.
Valued at 12.6x forward earnings estimates, international equities remain inexpensive relative to domestic. The equity index composition abroad is different from the U.S., with less exposure to large cap growth companies and more emphasis on value companies. As a result, international equities have historically traded at a 15% discount to the S&P 500 index and offer higher dividend yields. Currently the dividend yield is 1.6% higher and the valuation discount is nearly 2x the historical average.
A cyclical relationship between domestic and international equities is also evident. The chart below illustrates the cumulative outperformance of these cycles over the previous 50 years. Note the far right hand side – after a prolonged period of domestic equity dominance, a new cycle favoring international equities may be emerging.
Thus far the delta is marginal (+6%) and the time period is short (five quarters). That said, valuation differentials are wide, expected economic growth rates abroad exceed domestic, and despite recent declines, the U.S. dollar remains expensive – this combination of cyclical and structural themes are supportive of continued international equity outperformance.
We are optimistic about the prospects for diversified portfolios. Higher market yields from fixed income securities and reasonable valuations from global equities enables more balanced portfolio construction. Portfolios are less dependent on alternative investments for diversification today, which enhances our expectations for risk adjusted returns over the next market cycle.
We are grateful for your trust and confidence. Please let us know if you have questions, would like to discuss your financial plan or review your investment portfolio.
The JRM Investment Counsel Team
Jack, Phil and Lauren